S&P 500 Index 1769
By Steve Blumenthal
November 6, 2013
Trade Signals is designed to help you navigate the risks and rewards of the stock market. I believe a less certain investment outlook is ahead due to unmanageable debt, entitlements and unprecedented central bank manipulation. Debt deleveraging cycles are different than re-leveraging cycles. Required today is some form of risk mitigation. Fortunately, there are relatively inexpensive ways to protect your important long-term equity exposure.
Included in this week’s update:
- Sentiment Charts – Extreme Optimism: Establish Risk Protection Today (i.e. hedge long equity exposure)
- Cyclical Bull Market Charts – The cyclical bull market trend is aged but remains favorable
- American Association of Individual Investors Allocation Survey Chart – October 31, 2013 – A great chart showing the history of investors moving in to and out of equities (at the wrong times)
- My Two Cents and Current Market Valuation Targets
Investment Sentiment charts 11-5-2013:
Sentiment Chart 1. NDR Crowd Sentiment Poll – Remains Extreme Optimism: Establish Risk Protect/Hedge Long Equity Portfolio Exposure
Sentiment Chart 2. NDR Daily Trading Sentiment Composite – Also in the Extreme Optimism Zone.
Cyclical Bull or Cyclical Bear Market Trend Charts – Both Trend Charts Remain Bullish
Cyclical Trend Chart 1: 13/34-Week EMA – Note the blue 13-week EMA line remains above the red 34-week EMA line. Also note how well this simple, tactical indicator has historically captured the cyclical bull and bear market trends. Signals occur when the lines cross.
Cyclical Trend Chart 2: Big Mo remains in a Cyclical Bull trend
American Association of Individual Investors Allocation Survey – October 31, 2013
I have drawn what looks like two red balloons and two blue balloons. This survey from the American Association of Individual Investors polls 600 investors and asks what percentage of their portfolio is allocated to stocks, bonds and cash. At the market peak in March 2000, individual investors had 77% in stocks, 12% in cash and approximately 11% in bonds.
Note the high percentage of stock ownership at the market peak in 2000 (the first red balloon) and notice how stock ownership climbed from 42% in 1991 to over 75% by 2000. The amount allocated to cash was just 12%. A 50% decline in the S&P 500 Index and a 75% decline in the NASDAQ followed over the next two years. Investors left stocks in favor of cash and bonds.
At the market low in late 2002, stock ownership was at just 43%, cash increased significantly to 39% and bond ownership increased to 18% (the first blue balloon).
You can see this pattern play again in 2007 (high percentage stock ownership and low cash at the market peak in 2007 – second red balloon) and post crisis (low stock ownership and high cash at the market low in March 2009 – second blue balloon).
Today the percentage of an individual investor’s portfolio allocated to stocks has risen to 66% and cash has declined to 17%. Individual investor behavior is repetitive. It is driven by fear and greed. Let’s keep an eye on this chart in the immediate months ahead.
My two cents:
The cyclical bull market trend remains. It is important to stay with that trend; however, downside risk can be managed following a disciplined approach. Since investor sentiment is once again in the Extreme Optimism zone, now is a good time to risk protect. I favor a collared option strategy initiated when investor sentiment is extremely optimistic and removed when it is extremely pessimistic.
My best guess is for a sell-off into January with further rally to follow. This view is based on today’s excessive level of optimism and the charts supporting the current cyclical bull trend. Overall, the cyclical bull trend remains aged and market valuations are relatively overpriced (Median Fair Value at 1446 based on the most recent reported earnings using NDR’s Median PE calculation). Markets can grow to be more aged and even more overpriced. For now the cyclical trend remains positive.
A probable upside target is 1895 which represents a one standard deviation move above Median Fair Value. Thus I see the S&P 500 Index overvalued at approximately 1895. Let’s see what stock ownership and investor sentiment look like at that level.
Also supporting a continuation of the cyclical up trend is a strong dollar, foreign investor capital flows into US equities and pensions desperate to earn 8% (money flows from bonds to stocks). In the global race to debase one’s currency, we look just a bit prettier than the others. Thus, we likely benefit from capital inflows. Global liquidity crosses boarders quickly and the global central banks are doing all they can to create liquidity.
How much higher? Don’t know. How much longer? Don’t know. My best guess is a one standard deviation move above fair value is as good a target as any but it could be two standard deviations above though I think that is far less likely.
I am carefully watching for a change in trend. I favor the two cyclical trend charts reflected above and will recommend a far more conservative posture towards equities when the 13/34-week EMA chart or Big Mo indicate a shift from a Cyclical Bull trend to Cyclical Bear down trend.
Some form of an active approach to risk management is prudent. If hedges are now in place, look to remove them when Investor Sentiment moves back into the Extreme Pessimism zone (I favor the NDR Crowd Sentiment Poll as I’ve relied on it for years; however, others favor the Daily Sentiment Poll. Both charts are useful.).
The backdrop of low dividend yields, low inflation and low interest rates points to a low forward 10-year expected return. That means risk is higher today. Further, the macro fundamental picture remains challenged due to unmanageable levels of debt, unmanageable entitlements and unprecedented market manipulation from the world’s global central banks. It is not normal to have markets so manipulated.
We are in unchartered waters. Stay vigilant and construct portfolios that are broadly allocated to a diverse set of risks.
Wishing you the very best.
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Philadelphia – King of Prussia, PA
steve@cmgwealth.com
610-989-9090 Phone
For hedging, I favor a collared option approach (writing out of the money covered calls and buying out of the money put options) as a relatively inexpensive way to risk protect your long-term focused equity portfolio exposure. Also, consider buying deep out of the money put options for risk protection.
Please note the comments at the bottom of this Trade Signals discussing a collared option strategy to hedge equity exposure using investor sentiment extremes is a guide to entry and exit. Go to www.CBOE.com to learn more. Hire an experienced advisor to help you. Never write naked option positions.
Additional information and disclosures: I continue to favor a hedged approach towards long equity positions put in place from time to time tied to Investor Sentiment extremes. The cost of collared option protection (selling out of the money covered calls and buying out of the money puts) is relatively nominal compared to the potential downside market risks. You might also consider spending just 1% per year of your total equity exposure on buying deep out of the money put options. The purpose of Trade Signals is to begin a dialog around a disciplined risk management approach on core equity portfolio exposure.
33/33/34 – My broader view is outlined in a piece called The Portfolio Construction Game Plan for 2013. And subsequent posts at www.cmgwealth.com.
Modern Portfolio Theory is alive and well. The problem is that most portfolios do not include a broad enough set of important risk diversifiers and far too many individual investors chase into and out of the stock and bond market.
60/40 is not diversified in a low yield, low dividend, relatively high PE valuation world, yet those asset categories are important within the construct of a broadly diversified investment portfolio and the risks can be inexpensively hedged from time to time.
To me, a balanced portfolio today is comprised of 33% Equity (hedged from time to time), 33% Fixed Income (tactically managed) and 34% Tactical-Trading-Alternatives. Of course, you may allocate differently based on your risk level, age, needs, time horizon, etc.
Trade Signals was created with the intention of providing a disciplined process to hedge the long-term equity portion of a well diversified portfolio. You will be right from time to time and look like a genius in those moments and, frankly, you will also be wrong from time to time and look less than spectacular. I am far less concerned about getting a short-term directional call correct. I am more concerned about making money. For me, it is about inexpensive risk management in a high risk world. The cost of protection is nominal if executed correctly.
Investor sentiment indicators have helped me over the years and I hope that the statistical math behind investor sentiment extremes (human behavior) can help enhance the risk management of the equity portion of your portfolio(s) as well.
Overview: A disciplined equity hedge – risk management approach
Several times each year investor emotion reaches levels of Excessive Optimism and several times each year emotions reach levels of Extreme Pessimism. A strategy idea I favor is a disciplined risk management equity (hedge) approach as it relates to the long-term equity portion of a portfolio. Initiate hedges when investor sentiment reaches Excessive Optimism and remove hedges at periods of Extreme Pessimism.
A collared option strategy which involves writing covered out of the money calls and at the same time buying out of the money puts is something to consider. It is a relatively inexpensive hedge approach and allows your client to stay on plan with their long-term equity exposure. The game plan is to implement the hedge just a few times each year tied to sentiment extremes. Then remove hedges tied to Extreme Pessimism. Go to www.cboe.com and search for “collared option strategy” to learn more. I favor selling 5% out of the money calls and buying 5% out of the money puts with maturities several months out. It is important to manage to your risk tolerances/investment objectives but at most budget spending a small percentage of your equity exposure each year.
Given the overbought extremely optimistic nature of the market today, I believe spending a small amount of money to protect that long exposure is prudent.
Please note that this is absolutely not a recommendation to buy or sell any security. For discussion purposes only.
A note on active hedging
Within the long-term secular bear environment I believe we are in, I favor hedging the long-term equity portfolio exposure tied to periods of Extreme Optimism and removing those hedges tied to periods of Extreme Pessimism. As you can see in the above charts, there are just a few times each year that the market moves into “Extreme”. I like put options and covered calls against long equity exposure. Never sell “naked” put or call options. Another idea is to budget a percentage of your long equity exposure to actively put on and take off exposure to a leveraged inverse index based ETF.
I believe that we are in a period of time which favors actively hedging long equity exposure. I like putting hedges on when investors are extremely optimistic and removing hedges when investors are extremely pessimistic. The focus on the long equity portion of your portfolio is to enhance return, reduce risk and preserve capital. Go to www.cboe.com to learn more about options. All investments involve risk.
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by CMG Capital Management Group, Inc (or any of its related entities-together “CMG”) will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. No portion of the content should be construed as an offer or solicitation for the purchase or sale of any security. References to specific securities, investment programs or funds are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations to purchase or sell such securities.
Certain portions of the content may contain a discussion of, and/or provide access to, opinions and/or recommendations of CMG (and those of other investment and non-investment professionals) as of a specific prior date. Due to various factors, including changing market conditions, such discussion may no longer be reflective of current recommendations or opinions. Derivatives and options strategies are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from CMG or the professional advisors of your choosing. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisors of his/her choosing. CMG is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.
This presentation does not discuss, directly or indirectly, the amount of the profits or losses, realized or unrealized, by any CMG client from any specific funds or securities. Please note: In the event that CMG references performance results for an actual CMG portfolio, the results are reported net of advisory fees and inclusive of dividends. The performance referenced is that as determined and/or provided directly by the referenced funds and/or publishers, have not been independently verified, and do not reflect the performance of any specific CMG client. CMG clients may have experienced materially different performance based upon various factors during the corresponding time periods.
CMG SR Tactical Bond FundTM , CMG Global Equity FundTM and CMG Tactical Equity Strategy FundTM: Mutual Funds involve risk including possible loss of principal. An investor should consider the Fund’s investment objective, risks, charges, and expenses carefully before investing. This and other information about the CMG SR Tactical Bond FundTM, CMG Global Equity FundTM and CMG Tactical Equity Strategy FundTM is contained in each Fund’s prospectus, which can be obtained by calling 1-866-CMG-9456. Please read the prospectus carefully before investing. The CMG SR Tactical Bond FundTM, CMG Global Equity FundTM and CMG Tactical Equity Strategy FundTM are distributed by Northern Lights Distributors, LLC, Member FINRA. NOT FDIC INSURED. MAY LOSE VALUE. NO BANK GUARANTEE.
Hypothetical Presentations: To the extent that any portion of the content reflects hypothetical results that were achieved by means of the retroactive application of a back-tested model, such results have inherent limitations, including: (1) the model results do not reflect the results of actual trading using client assets, but were achieved by means of the retroactive application of the referenced models, certain aspects of which may have been designed with the benefit of hindsight; (2) back-tested performance may not reflect the impact that any material market or economic factors might have had on the adviser’s use of the model if the model had been used during the period to actually mange client assets; and, (3) CMG’s clients may have experienced investment results during the corresponding time periods that were materially different from those portrayed in the model. Please Also Note: Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that future performance will be profitable, or equal to any corresponding historical index. (i.e. S&P 500 Total Return or Dow Jones Wilshire U.S. 5000 Total Market Index) is also disclosed. For example, the S&P 500 Composite Total Return Index (the “S&P”) is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the stock market. Standard & Poor’s chooses the member companies for the S&P based on market size, liquidity, and industry group representation. Included are the common stocks of industrial, financial, utility, and transportation companies. The historical performance results of the S&P (and those of or all indices) and the model results do not reflect the deduction of transaction and custodial charges, nor the deduction of an investment management fee, the incurrence of which would have the effect of decreasing indicated historical performance results. For example, the deduction combined annual advisory and transaction fees of 1.00% over a 10 year period would decrease a 10% gross return to an 8.9% net return. The S&P is not an index into which an investor can directly invest. The historical S&P performance results (and those of all other indices) are provided exclusively for comparison purposes only, so as to provide general comparative information to assist an individual in determining whether the performance of a specific portfolio or model meets, or continues to meet, his/her investment objective(s). A corresponding description of the other comparative indices, are available from CMG upon request. It should not be assumed that any CMG holdings will correspond directly to any such comparative index. The model and indices performance results do not reflect the impact of taxes. CMG portfolios may be more or less volatile than the reflective indices and/or models.
In the event that there has been a change in an individual’s investment objective or financial situation, he/she is encouraged to consult with his/her investment professionals.
Written Disclosure Statement. CMG is an SEC registered investment adviser principally located in King of Prussia, PA. Stephen B. Blumenthal is CMG’s founder and CEO. Please note: The above views are those of CMG and its CEO, Stephen Blumenthal, and do not reflect those of any sub-advisor that CMG may engage to manage any CMG strategy. A copy of CMG’s current written disclosure statement discussing advisory services and fees is available upon request or via CMG’s internet web site at (http://www.cmgwealth.com/disclosures/advs).